The Sensex has fallen by over 20 per cent from its May 11, 2006 peak of 12671.  The correction was long expected as many market professionals thought that the implied price-earnings ratio  of nearly 20 was not unsustainable.  But the correction that came was not limited to the Indian market.  It was part of a broader global movement downward in equity and commodity prices.  It has to be understood then not just as a local correction but as a systemic down trend.

The reasons for the global downtrend are well known.  Macro-policy czars in the USA and Europe are worried about the resurgence of inflation.  Because of a period of sustained growth these economies are seen to be operating closer to capacity.  The deflationary impact of low cost imports from China, which kept price pressures down, is seen as less relevant with the up trend in the yuan.  High oil prices seem to be there to stay.  Even if the Iran tensions ease and there is no disruption the indications are that OPEC will not let prices drop below $ 50 a barrel.  That is why there has been a spate of interest rate increases, including in India where the RBI has also had to follow suit.  Globally the bearish trend will continue.

As far as India specific factors are concerned the underlying fundamentals determining stock prices seem sound.  GDP growth remains high, corporate earnings are growing at nearly 25 per cent and inflation seems to be under control.  The pressures have come from the herd instincts of fund managers as they fly to safety and redemption pressures from nervous investors who want to bail out before prices fall further.  Local fund managers are sending letters and emails urging that with the fall in stock prices, p-e ratios are nearly in bear territory and offer a god buying opportunity.  But not too many investors are listening to them!

A major reason for the volatility in the Indian stock markets in recent weeks has been the withdrawal of large sums of foreign portfolio investment in response to interest rate changes in the USA and Europe.  These FII inflows were also responsible for the preceding boom in stock prices.  But apart from these flows into the secondary market, we have seen a large number of private equity and venture fund investors from abroad coming into India.

The benefit to the foreign players from the high returns in the Indian market is obvious.  The question for us is whether they have helped us in broadening and deepening the capital market.

The central policy objective for capital market development must be to protect investors from fraud and to reduce the cost of raising capital for private investors.  The latter is the price that the borrower pays over and above the cost of capital defined by the interest rate structure.  It reflects market perceptions of risk and transaction costs.    Has the opening of the Indian capital market to foreign portfolio investors, private equity and venture funding firms helped to do this? 

When it comes to investor protection, the establishment of SEBI, the reforms in the trading system, pioneered by the NSE and later BSE, have brought us close to global best practice.  The opening of the mutual fund business to private player has widened options for private savers.  This is now reflected in growing investor faith in equity.  There are over 7 million share depository accounts and over Rs 200,000  crore invested in mutual funds. The improvement in the trading practices has also played a major role in attracting substantial volumes of portfolio investment into the primary and secondary market. Of course the driving force in the growth of the market is always fundamentals like the growth in GDP and corporate earnings.

What has happened at the borrowing end? Over 10000 companies are listed in Indian stock markets, though shares in only a quarter of these are regularly traded. The amounts raised from the primary market have increased from an average of Rs. 2300 crore in the eighties to over Rs. 30,000 crore in 2005-06. Here too the entry of foreign investors has widened the market and perhaps improved the quality of issuance practices.  However the system works mainly for the bigger, more established enterprises.

Many worthwhile propositions cannot go directly to the capital market and raise finance through the issue of publicly traded debt and equity.  This is particularly true for an operation that needs expansion finance to take it from a small or medium scale to a large scale. 

This is where private equity and venture funding comes in. Private equity is an off-market transaction. It will involve the exchange of equity.  But because the equity is not quoted, the investor is locked in for a period of say five to seven years.  The deal may also include all manner of covenants that give the investor firms a greater say in management decision-making than what is implicit in shareholder rights.  For these reasons private equity and venture capital flows are more stable in the sense that the investor cannot sell and get out quickly in response to some macro signal like an interest rate hike because the exit would have to be a negotiated sale to another investor or to the company.

The current outflow of FII money may inspire some to suggest a reversal of the open policies that have been followed.  This is not necessary.  We should resist anything that narrows the market or raises transaction costs unnecessarily.  But we should recognise the greater stability of private equity and venture fund flows relative to portfolio flows. 

We should also act to promote the emergence of domestically owned and managed asset management companies that can offer domestic and foreign investors the same service as the foreign asset managers, private equity companies and venture funds.  This is where a constrained sort of capital convertibility that would allow Indian asset managers to operate globally may help.  Then in volatile global circumstances there would be a two-way flow of funds that would moderate fluctuations in the local market.

Volatility requires resilience and that is best promoted by diversification.  This should be the goal of our capital market policy now.